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The Future of Social Security

August 22, 2006

Co-authored by Professor Noel Brodsky of Eastern Illinois University and Professor Joseph Finnerty of the University of Illinois

CHAMPAIGN, IL – Social Security is not at a crossroads. Within 30 years, it will cease to exist as a government program, at least in the form it is in today. It cannot be saved without radical changes in both the payment structure to those who are on it, the retirement age and financing. Politics will not be its undoing; demography is far more important in understanding why Social Security cannot survive.

The Social Security program has been described as a Ponzi game, and that’s not far from the truth. The program works as long as there are enough of those working paying in to support payments out to those retired. While a reserve of funds has been built up to support shortfalls of incoming payments, that can’t last indefinitely. For the program to remain viable there has to be a population structure which tends to be bottom heavy. This means there has to be a fairly large number of younger people relative to older people in the country’s structure. Such a structure is often called an Age-Sex Pyramid, which suggests a small older population and a large young one. This can be seen in Figure 1, where the relatively larger group of individuals at the bottom of the pyramid is able to support a relatively smaller retired population at the top of the pyramid.

Unfortunately, the United States already has lost most of its pyramid-like shape. By 2030, the structure will appear to be much more like a population rectangle. As the age-sex structure begins to flatten out, it becomes much harder for a system like Social Security to function. While the system works when those paying in are large relative to those paying out, it will fail when the ratio of young to old becomes more even. Unless the pyramid-like shape would reappear, virtually any reserve of funds would run out eventually. This can be seen in Figure 2, where an equal number of young people are paying in to support and equal number of retirees. Such a system is impossible to sustain without an income redistribution from the younger population to the older segment of the population.

Of course you can fix this with changes in the program that alter it in ways that make it unfair to those already in the system. They had a contract of promised benefits given certain contributions. The terms of conditions of the “contract” would have to be altered. You could raise the retirement age, perhaps to 75 or beyond, and reduce the payments to those already in the program. This would be a breach of contract for those already in the program. There would also be a large disincentive for those being asked to join the program.

So, is there an alternative to Social Security? The idea of private investment accounts may well be one of the few ways people can make the adjustment to a world without Social Security. The federal government needs to create incentives for people to save for their own retirement. This might be achieved with tax-based incentives and possibly some direct subsidies. We have something like that now, with 401(k) and IRA programs. These need to be expanded to allow for more savings flow, and perhaps better incentives. These incentives might include higher tax rates on income, or a consumption-based tax.

While it is unnecessary to open the country up to allow for free immigration, it is fairly clear that a more open immigration stance would keep our age structure more like a pyramid for longer. Immigrants tend to be younger, have large families and add dynamics to our economy. Like it or not, immigrants are good for the demographic structure of the United States. Immigration may extend the pyramid structure and allow for some additional time so that fundamental fixes to the system can go more smoothly.

Changes in federal policy can mitigate the eventual demise of Social Security. It is not the end of Social Security as we know it that is the important issue, but rather how will the retirement portion of an individual’s life cycle be handled. The question is how will the United States deal with providing for retirement, and perhaps more importantly, how will you?

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